Hunger Games The Fix Stuart Dear, Fund Manager, Fixed Income

August 2015
For professional investors only
The Fix
Hunger Games
Stuart Dear, Fund Manager, Fixed Income
Notwithstanding some volatility over the June quarter, fixed income markets remain caught between stretched
valuations – whether of sovereign rates or credit spreads – and an ongoing hunger for yield. The hunger for
yield, which contributes to the expensiveness of assets, is supported by stability of economic outcomes around trend growth and subdued inflation - and by the predictability of central bank policy responses, which
together have kept market volatility low. Not much has changed in this causal loop over the last several years
– economic outcomes have stayed moderate, central banks have stimulated more, and financial assets have
become more expensive.
The key conundrum is why all the policy support has not produced a stronger economic response. In part we
know the answer: there is still too much debt, and both the willingness to lend (due to impaired banking
systems and regulatory constraints) and the willingness to borrow (especially by corporates to invest) have
been low. Emerging economies have suffered similarly from high debt levels and a lack of demand from the
west, and more recently currency and commodity price shifts are exacerbating imbalances. Economists have
also recently been marking down estimates of long run growth in part because of these ‘debt overhang’
issues, as well as the issues around aging of western populations.
The related conundrum is the extent to which financial markets may ultimately be becoming more vulnerable
as a result of all the stimulation, which effectively is staying mostly within financial markets rather than being
redeployed in the ‘real economy’. Drawing the conundrums together, the world’s key central bank, the US Fed,
does appear to be moving towards a position where it feels it needs to tighten policy – in part because the US
economy has sufficiently recovered that zero rates are no longer required (but policy is still likely to remain
very accommodative), and in part because asset expensiveness combined with lower growth potential leave it
little firepower to stimulate in future if it doesn’t create room to do so.
We therefore appear to be approaching a point at which something gives – a change in central bank behaviour
may lead to a material cheapening of asset prices. Arguably we are already witnessing some of the moves;
USD strength is pressuring a range of dollar-linked and commodity-dependent economies, credit spreads
have been moving wider as corporates issue more to lock in low rates, and volatility has been ticking up. While
we don’t claim superior insight on the timing of Fed moves or other market-disruptive events, we do have a
relatively upbeat view of the US economy, and suggest it could be ‘sooner rather than later’.
All this leaves us with a portfolio that is defensively positioned, and increasingly so. We continue to run interest
rate duration at 1.7 years shorter than benchmark, primarily because core sovereign bond yields remain
considerably below fair value levels. Most of our short position is in the US, reflecting our view that the US
leads the cyclical recovery among developed economies, while we also have smaller short positions in
Germany and Australia (the latter of which also constitutes a material long absolute Australian duration
position given our relatively downbeat views about the domestic economy). Across the yield curve our short
exposures are roughly evenly distributed to protect both against Fed hikes causing repricing at the short end,
as well as a possible rebuild of global term premium at the long end.
We have also reduced credit exposure materially recently, on top of the progressive reduction in credit that
we’ve made over the last couple of years. Our recent reductions have mainly been from our global investment
grade corporate exposures, which at current valuations – though not excessively rich - are not especially
insulated from growing concerns around reduced liquidity and increasing volatility. This reduction takes us now
to only a modest overweight credit exposure, and has seen effective cash build up to more than 30%. We also
continue to run a collective underweight position to the non-credit spread sectors (i.e. semis and supras) given
the modest additional return they offer versus governments ahead of looming uncertainties.
Schroder Investment Management Australia Limited ABN 22 000 443 274
Australian Financial Services Licence 226473
Level 20 Angel Place, 123 Pitt Street, Sydney NSW 2000
For professional clients only. Not suitable for retail clients
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For professional investors only. Not suitable for retail clients.
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